How to Spot a Has-Been Stock

Have you ever yelled at the television in response to a news piece? I haven’t because I don’t watch TV news. But I have written letters to newspaper editors based on current issues. And I find that the older I get, the more I have opinions about what I read. (My wife says I’m getting cranky.) In any event, following, for better or worse, are my opinions and comments about 11 news stories this week.

1. State Farm Insurance is dropping homeowner policies in Florida, because state regulators won’t let the company charge what it wants. The state, of course, is trying to help people, but ends up hurting them by reducing competition and choice. I think insurance companies should be able to charge what they want, and the state regulators should get jobs where they actually produce something of value.

2. Brandeis University decided to close its art museum and sell its collection, worth perhaps $350 million (at least it was worth that last year), to cover a budget deficit and reinforce its endowment. Cleary, the school, which is dependent on the Jewish community for much of its support (it was almost named Einstein University), has been hit hard by the Madoff scandal as well as the general financial shrinkage. I predict that far more schools will take similar actions in the future as donations dry up and a tight credit market pushes students toward affordable schools that prepare them for real-world jobs.

3. The financial-services firm Edward Jones ranked No. 2 on Fortune Magazine’s 100 Best Companies to Work for 2009 . . . and ranked No. 1 for large-sized companies. The firm had little to no exposure to either high-risk mortgages or financial derivatives and it hired nearly 1,000 new advisers in 2008. Bravo! It took wisdom for management at this privately owned firm to see the right path, and courage to follow it, while so many competitors took the well-traveled wrong road.

4. Scientists discovered that repetitive head trauma in football players can cause chronic traumatic encephalopathy (a degenerative brain disease)–even in young players–and the news is expected to stimulate discussion about minimizing such concussions in youth programs. I hate to say it before Super Bowl weekend, but your brain is the most important part of your body, and when it gets hit, bad things happen, regardless of your age.

5 In Chicago, Governor Rod Blagojevich continues to insist he’s innocent, despite much FBI evidence to the contrary. In Boston, State Representative Diane Wilkerson says she’s innocent, too, despite a video of her stuffing cash under her clothes. And this week, the mayor of Hartford, Eddie Perez, admitted that he had a city contractor do $40,000 of work in his home, paying for it only when confronted by investigators, but he claims innocence and says he’s staying in the job. Have these people no shame? I hope there’s a special place in Hell for politicians who violate the public trust. At least Elliot Spitzer stepped down quietly.

6. Timothy Geithner won approval as Secretary of the Treasury, despite the fact that he’d failed to pay enough tax in 2001, 2002, 2003 and 2004. Do we need any more evidence that our tax code is too complicated? Simplify, simplify, simplify, and let thousands of CPAs and tax lawyers and lobbyists find productive work. Steve Forbes once had an idea for a postcard income tax return that was attractive for its simplicity, but he was woefully untelegenic, and his presidential campaign floundered.

7. A massive Web-attack by Russian “cyber-militia” knocked most of Kyrgyzstan offline in the past week. (Well, only 20% of Kyrgyzstan is online, so saying “most” is misleading.) But no one in the governments of Russia or Kyrgyzstan or the U.S. had any comment on the matter, which suggests they’re all woefully unprepared for cyber-battle.

8. Ford Motor lost $5.9 billion in the fourth quarter, but is still not asking for federal money and expects not to. Hooray for good management . . . or at least management that’s not as bad as GM’s.

9. The Senate voted to extend the nation’s switch to all-digital television from February 17 to June 12 (see my column from January 15). Like the individual politicians who refuse to acknowledge their transgressions, these folks in Washington, who have already spent $1.34 billion on the program to assist needy people in the transition, fail to recognize that they mismanaged the program. So they want more time and more money! Happily, the House said, “Nothing doing.” But it’s not over: the wrangling continues.

10. Starbucks has stopped automatically brewing decaffeinated coffee after noon. Now, they’ll brew on order, making the customer wait four minutes. Starbucks (SBUX) was an excellent investment from 1992 to 2006 . . . when the company was growing. But in recent months it’s announced the closing of 900 stores and the elimination of about 6,700 jobs. A better coffee investment might be Green Mountain Coffee Roasters (GMCR), whose Keurig cup individual brewing systems have taken over workplaces (including ours) and are now penetrating homes.

11. Finally, the FDA warned that consumers shouldn’t take the weight-loss pill “Venom Hyperdrive 3.0” because it contains a potent chemical–sibutramine–that can increase a user’s blood pressure and heart rate. With a name like “Venom Hyperdrive 3.0,” I’m not surprised.

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One of the hardest concepts for individual investors to grasp is the idea that the stock does not represent the company. In fact, the stock represents investors’ PERCEPTIONS of the company. If investors think a company’s future is bright, even though it is not yet a big success, they’ll pay a premium for their expectations–pushing the stock up in the process. Contrarily, if investors perceive that a company is becoming less successful, or simply growing less rapidly, its premium will shrink. In the worst cases, the stock will decline, even though the company is still growing!

For example, Intuitive Surgical (ISRG) is a company that makes million-dollar remote-controlled surgical systems that do minimally invasive surgery better than humans. It was a marvelous growth stock from 2004 to 2007, appearing in Cabot Top Ten Report 17 times. Its first appearance was August 2004 when it was trading at 23, and its last was December 2007 when it was trading at 328. At the peak, its P/E ratio (its premium) was 98! But then the company’s growth began to slow . . . and it’s still slowing. The growth rate of revenues in the past five quarters has slowed from 68% to 22%, while the growth rate of earnings has slowed in the past six quarters from 111% to (ready?) just 2%! Looking forward, analysts are projecting that earnings will grow just 2% in 2009.

In short, the perception of the company’s growth prospects has diminished dramatically. So the P/E (the premium) has shrunk to just 21. The stock has fallen from 328 to 103. And the trend is still down. How low it will go, no one knows, but I guarantee that when it bottoms it will be selling at a great discount . . . at which point bargain-hunters hunting for value will appear. But it’s not there yet.

What growth investors want to own are companies where perception is improving.

Last week, on January 22, Mike Cintolo, editor of Cabot Market Letter and Cabot Top Ten Report, wrote here about ITT Technical Institute (ESI), a stock that’s performing very well because investors are flooding into for-profit education stocks. The reason, of course, is that students young and old are taking courses to boost their employment prospects, so earnings expectations are being ratcheted up.

In the past four quarters, revenue growth rates at the school have increased from 12% to 15%, 14%, 17% and 21%. Analysts now project that earnings will grow 23% in 2009–and they’re usually conservative. We still like the stock (in fact we like several in the group), but note that a pullback toward 105 is not unlikely.

Yours in pursuit of wisdom and wealth,

Timothy LuttsPublisherCabot Wealth Advisory

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Market Update

From Cabot Top Ten Trader

The market remains in great shape, with all the major indexes in gear on the upside and, to this point, refusing to retreat much despite strong advances during the past few weeks. The next big test for stocks is earnings season, which is beginning to rev up and is sure to cause a few headaches, but also likely to cause some new leadership to lift off.